How Low Interest Rates Affect Pension Plans

Two weeks ago, I posted an article examining the health of Canadian defined-benefit pension plans in light of the battle between retired workers and the city of Detroit. I wanted to follow up with a basic educational article discussing how they work and why they are failing.

A pension plan is essentially a fund or scheme designed to provide funds at retirement. Contributions made by an employee through out his or her working life at a company eventually gets paid out when that worker retires. A defined-benefit plan determines the benefits to be received in the future, as is indicated in its name, it defines the benefits to the employee. In between that time, the fund will invest its assets in a number of investment vehicles. The problems that arose in Detroit and maybe for many in the future is that DB plans are only obligated to pay the debt if they can afford to. If a fund or employer declares bankruptcy, those obligations could become a part of a bankruptcy litigation.

The single biggest culprit to the failure of so many pension plans are interest rates. It is the backbone of economies because rates give value to assets and currencies, and determine the cost of borrowing. But when interest rates are as low as they have been, it significantly cuts returns. Although the chemical make-up of any pension plan will vary from company to company, most traditionally will invest in bonds, stocks, real estate, and other opportunities.

When interest rates are low, the income earned on bonds are reduced. In the world of lending, low interest rates push debt prices higher. If the government sets rates at 1 per cent, then a bond expiring in one year should yield about 1 per cent. The bond will be priced so that the purchaser of the bond (lender) receives just one per cent yield. So if the bond pays 3 per cent a year, the value of the bond must rise to offset the 3 per cent earned through interest income (known as the coupon). If a pension plan purchased a 10-year bond that matured (expired) today, the value of the bond will have risen and could be sold for a nice profit. But any new investment option purchased to replace it would be in the same asset class and yield less. And if rates do rise, then the value of the newly purchased bond will eventually decline.

Interest rates affect the prices of equities in the exact same manner with minor differences. The issue that money managers are faced with are low dividend yields as a result of low interest rates. Stocks are at all-time highs, yes, but money managers are in the business of creating income, not net worth.

The third common investment choice is real estate. Whether the property is a sky scraper or housing unit, these products are intended to earn income through rent or revenue-sharing. Think about it like this. You just bought a strip mall and rent out floor space to offices and business. A bad economy simply means lower demand for your space or lowered revenue-sharing opportunities. The value of your strip mall is moot because the intention of purchasing the mall was to generate income.

A reduction in the work force also negatively affects pension plans. When baby boomers retire, it pulls from the plan and obligations must be met. But, the supply and demand for workers continues to be low. Advancement in technology results in fewer workers required for the same job. And a struggling economy means companies are not ready to hire and worse, more ready to fire. The impact of employees matters for pension plans.

Pension plans are steady-state programs that use contributions from current members to pay owed retirees. Any difference is made up by withdrawing from the fund itself. Logically, the fund will release any cash first. Then, if a deficit remains, assets are sold. This is why income generation and cash flow is often more important than the net value of any fund. Combined with low interest rates yielding terrible returns and a smaller pool of workers to contribute to funds, we see that it is a recipe for the inevitable failure of many pension plans.

So, here is a long-winded summary of what money managers are faced with. Pension plans need high interest rates to survive. Central banks cut rates to spur economic growth, but it has failed. As a result, asset values rose to record highs creating low-yielding products for an extended period of time. Historically speaking, economic cycles hint that interest rates will rise, but based on tepid economic growth, rates will not rise until the pace of economic growth is comfortable. Rising interest rates are meant to deter growth. Since Central Banks are not yet ready to raise target rates, the only way to increase yields is to reduce the value of assets in some form. Now, with the baby boomers retiring and claiming benefits, pension plans must sell a chunk of assets at highs to offset shortages. This could be the supply side pressure needed to raise yields. However, these major moves hurt the economy and slow growth too, so businesses might cut hours or payroll numbers, mortgages rise, and demand for business space decline. Down the road, lower asset values means deficits are being offset by selling more asset units. And a reduction in contributions from fewer employees could be made up by increasing contribution payments, but reduces short-term money supply for the worker. A continued cycle exists all because the reduction in interest rates failed to spur growth.